Treading Lightly: No Tired Track for 2014

After a rather cathartic start to the year (equity markets tumbling at the
fastest pace in years) markets are again romping to the tune of the now familiar,
well-told story. While we celebrate new equity market highs, we think the old
story is tired; looking more like a re-tread here in early 2014. Why? Crucially,
because the global financial story is changing. We therefore now need to be
looking ahead ... not warming our old convictions on the hopes of a passing
story.

But first, let's review the soothing story that still seems to be warming
everyone's cockles.

Here are its major tenants and beliefs:

Economic growth is stable around the world. 2% GDP growth is low, but
not to worry, this is constructively positive.

Central banks have the upper hand and can artificially set prices indefinitely.
Interest rates will stay low and QE will continue to drive up asset prices
... even if not economic growth.

Various countries are cheapening their currencies and this is stimulative,
if anything. There is no risk of a deflationary shock.

Central bankers are on standby to apply the cardio-electrode thumpers
should economies, financial markets, or monetary systems again fall to
arrhythmia. Not to worry ... it has worked before. There is little risk
out there.

More government debt and more deficit spending is the solution to low
demand. There is no limit to the amount of debt that can be carried. After
all, the IMF just released an important Working Paper (WP/14/24) , concluding
that "we find no evidence of any particular debt threshold above which
medium-term growth prospects are dramatically compromised."

Corporations can continue to extract an ever greater proportion of national
income and convert it into profits and high dividend payouts. It is a gravy
train for equities. Is there any other choice?

Inflation is low ... and lower. This is good.

Europe can continue to be the global chump while Japan hugely raises its
export competitiveness. Germany can indefinitely continue to draw in a
huge export surplus from the rest of Europe without killing its host.

Emerging markets, though they may have some instabilities from time to
time, can be relied upon to continue growing faster than the developed
world. China can continue to paper over any problems with more credit and
bail-outs.

Gold is an anachronism (and for that matter, other commodities, too);
it has no intrinsic value; especially so in a low interest rate world.

That Shinto Abe (the Prime Minister of Japan) can continue to play the
confidence game of pulling the collective Japanese economy up by its own
petards. More QE, more recklessness, more prestidigitations, can continue
to bamboozle and foster more carry trade.

It has been a great script. Not because it holds much causal or theoretical
credibility, but because it has been joyously believed. Somewhat dangerously,
there's no one left to convert to this perspective. Mostly everyone is confident.

Never before have financial markets been as complicit with the bidding of
the central banks. Its players are in collusion with the narrative that the
central banks want to create, each signaling to the other that they must play
together to create a rising wealth effect -- the biggest unhinged financial
bubble of some time.

It's a colossal experiment that at some point will end up unfortunately, in
one way or another. We identify current conditions as a renewed financial bubble
that carries uncompensated risks. That's why we have been maintaining a cautious
stance in our portfolios. Timing and judging the possible extent of over-exuberance
is always problematic. Nevertheless, we think there will be rewards for the
prudent and patient. It has always worked out that way before.

Just what is the new story? It holds some very significant shifts. These,
in part, we think, will recognize the unsustainability of the past tenants
as well as patent theoretical falsehoods.

Here is the new story that we perceive is coming on the scene:

The most serious misreading is the inflation regime. Overindebtedness, secular
shifts , and the impact of technology betray an underlying disinflation (even
deflationary) influence despite what central banks may wish to do. There is
no way that profit growth can continue indefinitely in such an environment.
The cash economy, in nominal terms, is being gradually squeezed.

Crucially, emerging markets are now (have been) the world's locomotive. Once
upon a time, the world relied up the U.S. as its economic engine. When it pulled
out of the station, so did the rest of the world's economies ... eventually.
Right now, the U.S. is adding a slowing influence upon rest-of-world GDP growth.
Post the Global Financial Crisis, China and other less-advanced nations contributed
two-thirds of world GDP growth. That period (for now) is over. This is a critical
difference.

Economic growth still does not show any sign of acceleration. This has
been the major hope for 2014. It is not happening. It is becoming ever
more difficult to believe in the tooth fairy.

It is now more than five years post-GFC and central banks are still seeking
to stimulate economic growth. The record has been catastrophic. In the
meantime, economies have become inured to near-zero interest rates and
continual QE. That means that the next economic recession (and surely one
will arrive eventually) will occur with policy interest rates still near
zero. That will be a first. That such an outlook would be celebrated with
inflated asset values (including the stock market) begs incredulity.

Financial systems are again vulnerable to instability. Speculative financial
positions are again high and unsustainable. Financial excesses are again
evident virtually everywhere. What this means (usually) is that policy
reversals or accidents are likely to meet ill-prepared markets.

The gold price is the reciprocal of the collective faith put in central
banks. Yes, right now central bankers are received as the Masters of the
Universe. But money has a metaphysical power born of collective humanity's
will to pursue and preserve wealth. All manipulated, fiat money systems
have failed throughout history. For now, at the very least, gold-related
holdings are still merited for insurance purposes and also as an insulation
to malingering deflationary forces. And, if 2014 finally does cast aspersions
on the immortality and foresight of central bankers, gold will prove to
be a resilient investment this year.

The denouement of the central banking confidence game may likely already
be in sight. That we see in Japan. The Abe "confidence" boost is playing
out. Massive QE has still not boosted GDP growth ... and that is the case,
even without the slowing impacts of Abe's "third arrow" of reforms.

In Europe this year the European Central Bank (ECB) will be stress testing
130 major banks as it prepares to assume the role of a common European
regulator. We expect that this will show that the quality of assets on
the banks' books are much poorer than commonly believed. (The same is also
true in the U.S.).

All in all, we remain in a new, uncharted monetary environment. Just as
economic and monetary policies have been unprecedented to this point (i.e.
... QE, OPMF ... etc.) so will be the next monetary tightening phase. In
fact, it is already here. It will likely not take the form of rising interest
rates (as everyone expects) but in terms of lower QE (that's what the "taper" is
all about); or simply, even lower monetary velocity; and/or further waning
impact of QE. The message? The next tightening phase is underway. Caution
is in order.

Yes, we too want to believe that the old story will continue indefinitely.
But, more than that, we want to make sure that our clients aren't vulnerable
to yet another reckless, feckless financial bubble ... remarkably, the third
one in 15 years.

We may risk missing the last "high risk" returns that are being extracted
from libidinous investor enthusiasm (misplaced as we believe that it is). However,
as our track record well proves, it's how much one keeps during the inclement
financial times that is a major determinant of long-term returns.

The third financial bubble in 15 years is underway at present. No one can
really know how far it may yet expand. The extremities of human emotions and
possible policy responses really cannot be forecast in 2014. What we do know
for certain is that overall investment risks have again risen. Our current
investment policies have been adjusted accordingly. We remain broadly and globally
diversified, holding some insurance as well as relying on higher yields.

Wilfred Hahn is intimately familiar with the many facets and challenges of
the world of money, having worked in the global financial and investment industry
for over two decades.

Business and research travels have brought Wilfred to 40 countries around
the world, allowing him a unique opportunity to keep abreast of global developments
and to maintain an international network of contacts. He is a published author
and has written on global financial markets, ethics and stewardship issues.
When Euromoney Magazine asked fund managers around the world to name
their favorite domestic and international research analysts, Wilfred was chosen
one of them. Many foreign publications around the world have quoted Wilfred,
including the South China Morning Post, Wall Street Journal, New York Times,
Frankfurter Allgemeine, and the Financial Post. He has made numerous
appearances on various television and radio broadcasts.

Prior to founding Hahn Investment Stewards, Wilfred was head of the Global
Investment Group of the Royal Bank of Canada. In this position, he built the
global discretionary business of this institution, comprising the activities
of staff in nine countries and assets of clients totaling in excess of $10
billion. The group's many clients around the world included pension funds,
corporations, mutual fund unit-holders and private individuals.

Prior to the Royal Bank he co-founded Hahn Capital Partners Inc. - a global
investment counseling firm that was sold to the Royal Bank of Canada. Earlier
in his career Wilfred was Senior Vice President, Director of Research of Prudential
Bache Securities. There he gained extensive global experience, establishing
a high ranking as a financial market strategist. Earlier, Wilfred was a partner
in the investment banking firm of Gordon Capital Inc.